What is a loan between individuals?
To understand peer-to-peer lending, it helps to start with the difference between this loan and a traditional loan. There are two types of peer-to-peer loans: personal and small business. Unlike a traditional loan, a loan between individuals is financed by investors or a group of investors. Also called “P2P” or “crowdlending”, these loans are only available on online markets. After a person applies for a loan, the market (or the lender) matches the borrowers with investors who are willing to make the loan. It is the market that reviews loan applications, underwrites the loan and assigns it to a risk category.
The assigned risk category is based on factors such as credit rating, debt ratio and work history. Here’s how it works: An applicant with a low credit score is considered a high-risk borrower. Any P2P lender (or lenders) who agrees to lend money to this person knows that they are taking a risk. Therefore, the interest rate on the loan is fixed higher. This higher interest rate is the reason why some lenders choose this borrower profile over others.
On the other hand, a person with a high credit score (and other positive credit factors, such as a low debt ratio), is classified as low risk. Although the lenders do not earn as much interest by financing this loan, they also take on less risk.
For an investor who wants to “mix” their loan portfolio, it makes sense to fund high-risk loans and low-risk loans, but it depends on the investor.
Secured and unsecured loans
A secured loan is secured by collateral. Suppose a small business wants to borrow $100,000. To help minimize the risk of lending that much money, a P2P lending platform may require the business to post collateral. It can be valuables, from a small plane to a vintage car, to professional equipment. If the borrower fails to make payments as agreed, the lender has the right to take possession of the collateral, sell it and recover the loss.
An unsecured loan requires no collateral, but may carry a higher interest rate. Still, if you’ve decided that financing a project is better than paying cash, it may be worth paying a bit more interest for a loan that doesn’t require collateral.
How to apply for a loan between individuals
The best peer-to-peer lenders make it easy to apply through their websites. Here is the information and documentation you will need to provide:
- Date of Birth
- Proof of employment
- proof of income
- Social Security number
- Personal information, such as whether you currently rent or own your home and how much debt you have
- If you are applying with a co-signer, you will need to provide that person’s information as well.
Apply from a position of strength
As you’ve probably noticed, the lowest rates and the best loan options go to those with the highest credit scores and the best overall financial situation. One of the worst mistakes a borrower can make is believing that they have no control over their credit rating or that they have to accept the interest rate offered to them. It is simply wrong. If you’re taking out a loan to renovate your home, go on vacation, or for any other reason that can wait, decide if you can defer the loan until you’ve had time to improve your credit score.
Here are five ways to quickly increase your score.
1. Check your credit report
Once a year you are entitled to a free credit report from each of the “big three” credit reporting agencies. You can order your free reports from Experian, TransUnion and Equifax by submitting a simple form to annualcreditreport.com. Once you have your reports in hand, go through them with a fine-toothed comb.
Looking for any errors that may be contained in these reports. For example, a report may show that you still owe money on a debt that you paid off or include a debt that is not yours. If you find an error, dispute it with the credit reporting agency in question. The agency has 45 days to find proof that its report is correct or to withdraw the remark. Even the smallest mistake in your credit history can lower your score, so make sure there isn’t one.
2. Keep track of your bills
Every late or missed payment lowers your credit score. In addition to paying all routine bills on time, focus on catching up on anything that might be overdue.
3. Don’t close paid accounts
Closing unused credit card accounts may sound like a good idea, but it will actually hurt your credit score. By keeping them open, you indicate that you have access to credit, but that you are using it wisely.
4. Ask for credit only when you need it
Your credit report shows every time you apply for credit, and creditors are concerned for anyone who appears to be opening multiple accounts for a short period of time. Apply only for the credit you really need.
5. Get outside help
Things like rent paid to a landlord and utility payments are generally not reported to credit bureaus. Into this vacuum, companies have stepped in that, for a fee, will ensure that rent and utility payments are reported to the big three credit reporting agencies. These positive reports can quickly boost your credit score. However, there are fees involved. For example, ExtraCredit.com charges $24.99 for the service. If you’re looking to build your credit score quickly, this is worth looking into.
Most peer-to-peer lenders do a soft credit check, which means it won’t impact your credit score. It is only when you engage with a lender that they do a rigorous credit check which will affect your score a bit. Don’t worry, though. A few one-time payments will return your score.
Apply to at least three lenders (within two weeks so that all personal loan applications appear as one on your credit report). Once you’ve gotten the approvals, compare them side by side to figure out which one is right for you. The best way to pay off a loan quickly is to go with the lender that has the lowest interest rate and loan fees.
When P2P lending makes sense
If any of the following apply to you, include peer-to-peer lenders when shopping for a personal loan. Even if you end up with a traditional lender, you’ll know you’ve researched all options.
- You have a low credit score. If you find that you don’t qualify for a traditional personal loan due to poor credit, you may find a more lenient peer-to-peer lender.
- You have a high credit score. When comparing the best personal loans, include a few peer-to-peer lenders. It may be a peer-to-peer lender that offers the lowest rate and best loan terms.
- You own a small business. If you have a business plan that makes sense and you are confident you can repay the loan, a business loan can help.